We cover 4 methods of valuing inventory in this guide:
- The FIFO method
- Weighted Average Cost
- The LIFO method for valuing inventory
- Specific Identification
Businesses value their inventory for a variety of reasons, including for financial reporting, tax purposes, and business decision-making. Under the International Financial Reporting Standards (IFRS) standard, companies are required to record the value of their inventory at the “lower of cost and net realizable value”.
Net realizable value (NRV) is the expected selling price of the inventory goods less selling costs. It is based on what the goods are currently worth rather than their original cost. NRV takes into account that the value of inventory can decline below its original cost for reasons including obsolescence, damage, or spoilage. When this happens, the original cost of the goods should be written down to its NRV to reflect the loss in value. The “lower of cost and net realizable value” principle is used to ensure the value of inventory is not overstated on company financial statements.
Inventories are initially valued at their cost and are only written down to NRV if their value declines below cost. Cost is the acquisition price of the inventory but it can also include other costs that are incurred to get the inventory ready for sale. Under IFRS first-in first-out (FIFO), weighted average cost (WAC) and last-in first-out (LIFO) are all acceptable methods of determining cost. When a method is chosen, it should be used consistently throughout the existence of the business in order to make good comparisons from year to year.
The below formula for the Product X example will be used to calculate the value of closing inventory at the end of the period using each of the three cost flow assumptions: FIFO, WAC, and LIFO.
Opening Inventory (OI) + Purchases (P) – Cost of Goods Sold (COGS) = Closing Inventory
Week 1: Bought 10 at $1
Week 2: Bought 10 at $1.50
Week 3: Sold 15 at $2
1. The FIFO Method of Valuing Inventory
The FIFO (First in, First Out) method assumes the first goods purchased are the first to be sold. The inventory that remains unsold at the end of the period will be valued at the most recent prices. This method is most often used by businesses that sell perishable goods like supermarkets. These businesses will usually organize or display their goods in a way to ensure customers purchase the oldest goods first. Under FIFO, we can determine the total value of Product X at the end of the period in the below calculation.
OI ($0) + P (10 x $1 + 10 x $1.50) – COGS (10 x $1 + 5 x $1.50) = Closing Inventory ($7.50)
OI ($0) + P ($25) – COGS ($17.50) = Closing Inventory ($7.50)
The example illustrated reflects our inflation-based economy. So when comparing FIFO to the WAC and LIFO methods, we will see that FIFO will have the highest closing inventory and the lowest COGS. The low COGS value will result in this method producing the highest net profit and income tax.
2. The Weighted Average Cost Method
This method allocates the cost of goods available for sale based on weighted average cost. It is commonly used by businesses like manufacturers where their goods are similar in nature and cannot be easily differentiated by the date it was purchased. Using the formula below, the closing inventory value of Product X is calculated by dividing the total cost of goods available for sale by the total number of units available for sale and multiplying it by the unsold units.
(Total Cost/Total Units)*Unsold Units = Closing Inventory (WAC)
(10 x $1 + 10 x $1.50)/20 x 5 = Closing Inventory ($6.25)
3. The LIFO Method
Under the LIFO (Last in, First Out) method, it is assumed the last goods purchased are the first to be sold. The inventory that remains unsold at the end of the period will be valued at the oldest prices. LIFO is prohibited under IFRS due to potential distortions that it may have on company financial statements. Assuming rising prices, this method can be used by companies to reduce profits so they can pay lower income taxes. Under LIFO, we can determine the total value of Product X at the end of the period in the below calculation.
OI ($0) + P (10 x $1 + 10 x $1.50) – COGS (10 x $1.50 + 5 x $1.00) = Closing Inventory ($5.00)
OI ($0) + P ($25) – COGS ($20) = Closing Inventory ($5.00)
When comparing this method to WAC and FIFO, we will see that LIFO will have the lowest closing stock value and the highest COGS. The high COGS value will result in this method producing the lowest net profit and income tax.
4. The Specific Identification Method of Valuing Inventory
The specific identification method is used when the cost of an individual stock item can be positively identified from the time of purchase to the time of sale. This method requires tedious record keeping compared to the other methods and is more commonly used for low volume, large value items such as cars, fine jewelry and paintings.